High & Low FinanceFamiliarity Breeds Gloom Among Financial Experts

NY Times,

By FLOYD NORRIS
DAVOS, Switzerland
The closer you are to financial markets, the glummer you are.This has not been an unreservedly negative year at the World EconomicForum, the annual gathering of business and economic leaders at this skiresort, even if Klaus Schwab, the major-domo of the event, did feelcalled upon to try to cheer up attendees at the forum?s formal opening.?I know the mood is different from last year,? he said, ?but we do notwant to fall into gloom and doom.?Many have not done so. There has been optimism from some Americanbusiness executives, who say they have yet to see weakness in theirsales. Richard N. Cooper, an economist from Harvard, said his best guesswas that while the American economy was slowing, it would not fall intorecession. He said he doubted that consumer spending would reallycontract so sharply that it would bring down the economy.Others forecast that the rest of the world will keep growing even if theAmerican economy tanks.?This is the first time that the world is looking at a possible Americanrecession with two engines of growth: China and India,? said Kamal Nath,India?s minister of commerce and industry.?The momentum of growth is increasing year by year,? he added. ?It willtake a great recession to stop this momentum.?But the pessimism is much greater among those closest to the financialsystem. While some take a functioning financial system for granted, inthe same way they view highways or indoor plumbing, others see a systemin crisis.?We?re entering a perfect storm, a period of financial turbulence andvery limited capital,? said one executive, whose company needs to borrowmoney to grow.?What?s driving everyone crazy,? another executive said, ?is, you don?tknow who you can trust.? Both are well-known executives who did not wantto call attention to themselves.The new lack of trust has virtually closed down the securitizationsystem that financed many companies and many mortgages. It has shakenother markets, where traders worry that counterparties ? the people theytrade with ? will not be able to perform on contracts that may requirelarge payments years later.?It?s like walking blind in a minefield,? said Nouriel Roubini, a NewYork University economics professor who warned of an impending creditcrisis at this conference a year ago. ?You have no idea if yourcounterparty has a lot of toxic waste, or not much.?Established financial markets dealt with that issue generations ago byusing exchanges and standardized contracts. The exchange monitored thehealth of its members and guaranteed the trades. If you put in an orderto sell 100 shares of I.B.M., it doesn?t matter to you if the buyerdefaults. You will get your money anyway.But in the over-the-counter market for financial derivatives, each tradedepends on the counterparty. Many deal only with established banks, andthe banks are expected to monitor the standing of the people they tradewith.Until this summer, it was easy to trust the banks. The Basel II capitalguidelines for banks, now being phased in around the world, even reliedon the banks? own credit evaluations to decide how much capital theyneeded to back a given loan.But what appeared to be a well-capitalized financial system has turnedout to be the opposite, as big bank after big bank has had to seek hugecapital infusions. Securities that banks had been able to keep offbalance sheets ? Mr. Roubini says regulators should never have allowedsuch things ? have come back just in time to provide large losses.?We did not,? an executive of one financial institution said, ?fullyunderstand the extent of the risks? in some securities. For obviousreasons, he did not want to be identified.The newest big loss shows the problem is spreading.On Thursday, Soci?t? G?n?rale, the big French bank, reported that it hadto write down 2 billion euros because of the same kind of problems thathave besieged American banks. That was bad enough, but it also said itlost 4.9 billion euros from trading in European stock index futures.Soci?t? G?n?rale said a trader had exceeded his trading limits.The lack of trust has intensified because some banks offset big risks bypurchasing insurance against defaults, and now the insurance seemsdicey. The so-called monoline insurers, like MBIA, are in danger oflosing their AAA ratings, and some have already done so.Even worse, at least potentially, are the risks from credit defaultswaps, which have become a $45 trillion business. George Soros, thelegendary hedge fund manager, called in reporters here to warn that someof those swaps had been sold by hedge funds that might be unable to payif there were a wave of defaults by corporate borrowers.His proposed method of dealing with that seemed unlikely to winapproval, but it was interesting because of the extent of fear it showed.He wants bank regulators to go in and audit the big financialinstitutions, and then either close them down or give them clean billsof health, with explicit guarantees of their positions. Then traderswould know some counterparties were safe.That such an idea could cost the Treasury billions, or give bigfinancial advantages to the favored banks, or even amount to practicalnationalization, did not seem to bother Mr. Soros. He is worried aboutthe possibility of ?systemic collapse.?The fear at this forum is among the financiers.